adoption of revenue risk management and why knowing your income over feed cost is important brian w....
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Adoption of Revenue Risk Management and Why Knowing Your Income Over
Feed Cost is Important
Brian W. GouldDepartment of Agricultural and Applied Economics
University of Wisconsin-MadisonUniversity of Wisconsin Extension
October 4, 2013
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Overview of Income Over Feed Cost (IOFC) trends
Some examples of relatively simple margin risk management strategies
What does using these strategies mean with respect to your own operation
Today’s Presentation
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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20122013
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California and Upper Midwest Mailbox PricesUMW
CA
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Monthly Mailbox Price: CA and UMW
% Change in Mailbox Prices UMW CA
Nov ʹ07–Jul ʹ09 −47.3 −53.4Jul ʹ09– Aug ʹ11 98.0 106.8Correlation Coefficient = 0.96
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U.S. Average DSA Ration Costs
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DSA Ration(Per cwt of Milk)
Weight: 102.2 lbs59% Corn14% SBM27% Alfalfa Hay
DSA Ration(Per cwt of Milk)
Weight: 102.2 lbs59% Corn14% SBM27% Alfalfa Hay
Apr ʹ10 – Aug ʹ12: 105.9%↑Apr ʹ10 – Aug ʹ12: 105.9%↑
Dairy Security Act Feed Costs
DSA = Dairy Security Act
$14.56
$2.25$2.73
$7.54
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FMMO Average Mailbox Over Feed Cost Margin
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Dairy Margin Volatility
Margin = FMMO Mailbox Price – DSA Ration Cost
FMMO = Federal Milk Marketing Orders
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Probability
of 5%
Probability
of 15%
Probability
of 60%
Probability
of 15%
Probability
of 5%
PotentialIOFC Range
#1
< $3/cwt
Sum to 100%
> $9/cwt$5 − $7/cwt
ActualIOFC
PotentialIOFC Range
#2
PotentialIOFC Range
#3
PotentialIOFC Range
#4
PotentialIOFC Range
#5
How Would You Characterize the Degree of Your Margin Risk?
All Possible Outcomes
ExpectedIOFC Risk
$3 − $5/cwt
$7 − $9/cwt
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Margin risk exists if there are Alternative IOFC outcomes Unsure as to which outcome will actually occur
Margin risk increases the more you don’t know about:Potential outcomes (i.e., alternative IOFC levels)Outcome probability (i.e., likelihood of an IOFC
range occurring)Implications of each outcome on farm profitability
How Would You Characterize the Degree of Your Margin Risk?
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WRT Your Farm’s IOFC Do You Know:
The range of IOFC’s you’ve achieved over the last 5, 10, 15 or 20 years? These are the potential IOFC outcomes
The proportion of months a particular IOFC range have occurred since 2000? IOFC ($/cwt): $4, $6, $8 Can use to provide an estimate of event probability
Implications of alternative IOFC’s on sustainability? What are your non-feed costs of production?What are your fixed versus variable costs
of production?
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How Would You Characterize the Degree of Your Margin Risk?
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% o
f M
onth
s (J
an. '
95 -
May
'13)
Mailbox Price Range ($/cwt)
Distribution of Monthly Mailbox Prices
Upper Midwest
CaliforniaAverage Std.Dev.
($/cwt)
FMMO 15.04 2.99
UMW 15.07 3.06
CA 13.77 2.68
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100C
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f M
onth
s (J
an. '
95 -
May
'13)
Mailbox Price Range ($/cwt)
Cummulative Distribution of Mailbox Prices
Upper Midwest
California
29.9% Probability that CA Mailbox ≥ $15/cwt
44.8% Probability that UMW Mailbox ≥ $15/cwt
0.0
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7.5
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17.5
20.0%
of
Mon
ths
(Jan
.'05
-M
ay '1
3)
Feed Cost Range ($/cwt of Milk)
Distriubtion of DSA Ration Cost
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How Would You Characterize the Degree of Your Margin Risk?
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Cum
mul
ativ
e %
of
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ths
(Jan
.'05
-M
ay '1
3)
Feed Cost Range ($/cwt of Milk)
Cummulative Distriubtion of DSA Ration Cost DSA Ration(Per cwt of Milk)
Weight: 102.2 lbs 59% Corn 14% SBM 27% Alfalfa Hay
DSA Ration(Per cwt of Milk)
Weight: 102.2 lbs 59% Corn 14% SBM 27% Alfalfa Hay
20.2% Probability thatRation Cost is ≥ $12/cwt
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How Would You Characterize the Degree of Your Margin Risk?
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% o
f M
onth
s (J
an.'0
5 -
May
'13)
IOFC Range ($/cwt)
Distriubtion of FMMO Mailbox IOFC
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% o
f M
onth
s (J
an.'0
5 -
May
'13)
IOFC Range ($/cwt)
Cummulative Distriubtion of FMMO Mailbox IOFC
30.8% Probability thatIOFC is ≥ $9/cwt
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Objectives of Margin Risk Management
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If you purchase worker’s compensation insurance for your employees, do you hope that you have to use it? Assures your asset base is protected if an
accident should occurExample of risk managementThere is a cost for this protectionWhat are you willing to pay to avoid major
financial hit?
Analogous to undertaking financial risk management efforts
What is Margin Risk Management?
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Margin Risk Management Principle: By undertaking a management strategy one can increase the probability of achieving a desired margin outcome where: Desired outcome needs to be realistic Outcome target needs to account for current market
conditions What can one actually achieve given market?
What is Margin Risk Management?
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Margin risk management is like any other input with both cash and opportunity costs↓ risk may involve either reduced returns or
range of returns: Risk-Return TradeoffWhat tradeoff level is acceptable to you?Associated tradeoffs vary across strategy:
Objective #1: Set a fixed IOFC → can’t take advantage of higher milk price/lower feed costs without incurring additional costs
Objective #2: Establish an IOFC floor → Can take advantage of higher IOFC’s either due to higher milk prices and/or lower feed costs without additional costs
What is Margin Risk Management?
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With current mechanisms how can a producer manage his/her margin risk? Strategy #1: Use forward price contracts for
milk and feed → fixed IOFC
→ IOFC will stay at IOFC* regardless of market prices
Does IOFC* cover non-feed production costs?
$/cwt milk
IOFC*
Milk/Feed Prices
Fixed Milk Price
Fixed Feed Cost
Examples of Margin Risk Management
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Strategy #2: Forward milk price contract and feed call options → IOFC floor
Purchasing a CALL option conveys the right, but not the obligation, to purchase a futures contract at a given price Option price (i.e., the premium) depends on:
Option’s strike price relative to current futures price (+)
Time to expiration (+) Futures price volatility (+)
Examples of Margin Risk Management
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Strategy #2: Forward milk price contract and feed call options → IOFC floor
→ IOFC will able to be increased when feed price goes below $C* by exercising call
$/cwt Milk
IOFC*
Milk/Feed Prices
Fixed Milk Price
$C Feed Call
C*
IOFC**
Examples of Margin Risk Management
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Strategy #3: Class III put options and forward feed price contract → IOFC Floor
Purchasing a PUT option conveys the right – but not the obligation – to SELL a futures contract at a given price → Results in you receiving a net milk price at
a future date at the option’s strike price net your costs
Examples of Margin Risk Management
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Strategy #3: Class III put options and fixed forward feed price contract → IOFC Floor
→ IOFC will able to be increased with Announced Class III price more than $P
$/cwt Milk
IOFC*
Milk/Feed Prices
Feed Price: $C
Class III Put: $P
$P
IOFC**
Examples of Margin Risk Management
Strategy #4: Purchase both Class III puts and feed equivalent calls → IOFC Floor
$A is the minimum IOFC = $P − $C Higher IOFC: $A + $B, $A + $C, or $A + $B + $C
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$/cwt Milk Milk revenue floor
Feed cost ceiling$A
$C
$B
$P
Class III Put: $P
Feed-Based Call: $C
$CMilk/Feed Prices
Examples of Margin Risk Management
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Strategy #5: Instead of Class III Put option, purchase minimum price contract from processing plant→ IOFC FloorPlant collects minimum price contract offers
across farms to determine number of Put options to purchase on their behalf Plant decreases contract offer to cover commission
and own administrative costs
If cash price less than contract price → milk check is increased by difference times contracted quantity
Examples of Margin Risk Management
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Strategy #6: Use a Min/Max (Collar) milk price contract to set a Class III price range → IOFC Floor Producer select’s milk price floor and ceiling
that fits price goal Floor protects from low milk prices Ceiling on revenue reduces contract cost Contract price is the USDA Announced price
should that price be between floor and ceiling
Examples of Margin Risk Management
Strategy #6: Combining Min/Max milk price and feed calls → IOFC Floor
Minimum IOFC = $A Higher margins: $A+ $C, $A+ $B, or $A+ $B + $C
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$/cwt Milk
Milk revenue range
Feed cost ceiling$A
$C
$B
$PL
Min Milk Price: $PL
Feed-Based Call: $C
C*Milk/Feed Prices
Max Milk Price: $PU
$PU
Examples of Margin Risk Management
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Strategy #7: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) → IOFC Floor Similar to put/call options strategy except:
No options actually purchased No minimum size limit Upper limit: 240,000 cwt over 10 mo./insurance yr Premium not due until after 11-month insurance
period regardless of no. of months’ insured Subsidized premiums (i.e., 18% - 50%).
Pilot program with limited funding (<$20 Mil)
Examples of Margin Risk Management
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LGM-Dairy is customizable with respect to: Number of months insured by 1 contract
1 – 10 months % of monthly IOFC (marketings) insured
0 – 100% of certified marketings % coverage can vary across month
Farm specific insurance characteristics Amount of marketings insured Declared feed use: Only protect market-based risk? Deductible and resulting premium subsidy Premium specific to farm and contract design
Available for purchase on last business Friday each month
Examples of Margin Risk Management
LGM-Dairy: Class III, corn, and soybean meal futures markets used as information source to determine Expected (forward looking) and Actual (final) prices No futures market transactions Actual farm prices not used No local basis added to prices Expected prices known at sign-up
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Examples of Margin Risk Management
Total Expected Gross Margin (TEGM) = Contract Expected milk value – feed costs = Sum of monthly (Expected milk prices x
Insured milk) – Sum of monthly (Expected feed prices x Declared feed use)
Single TEGM regardless of months insured
Insurance Deductible: Portion of TEGM not covered by insurance Higher deductible → Lower premium
Producer assumes more risk Subsidy increases with higher deductible
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Examples of Margin Risk Management
Total Actual Gross Margin (TAGM) = Total Actual contract milk value – Total Actual contract feed cost = Sum of monthly (Actual milk prices x
Insured milk) – Sum of monthly (Actual feed prices x Insured feed use)
No monthly determination of TAGM
If TGMG > TAGM → Indemnity = TGMG – TAGM Market did not live up to expectations Only 1 indemnity calculation per contract
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Examples of Margin Risk Management
Current House and Senate versions Replaces current Federal dairy programs with:
Voluntary Dairy Producer Margin Protection Program (DPMPP) in Senate and House versions
A voluntary Dairy Market Stabilization Program (DMSP) in Senate version
DPMPP Objective: Reduce margin volatility Margin insurance program with limited contract
flexibility: Same feed ration for all participants All feed assumed to be purchased
IOFC margin defined as the difference between U.S. average All-Milk price and ration cost
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Margin Risk Management: 2013 Farm Bill
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DPMPP Insurance: $4.00 Base Margin Insurance @ $0 cost Indemnity = difference between average
actual margin for consecutive 2-month period and $4.00
Coverage is the lesser of 80% of production history divided by 6 or Actual quantity of milk marketed during
consecutive 2-month period Growth option for base is possible
Margin Risk Management: 2013 Farm Bill
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Supplemental DPMPP Insurance: From $4.50 to $8.00/cwt Cover 25% to 90% of base Indemnity = difference between target and
higher of the actual average 2 month margin or $4.00
Coverage is purchased coverage % times the lesser of:Annual production history divided by 6 orActual amount of milk marketed over the
previous 2-month period
Margin Risk Management: 2013 Farm Bill
• DPMPP premiums vary by farm size• 4 Mil. Lbs. is the boundary between premium
schedules• House and Senate versions have similar
premium schedules• Premiums still subsidized, although not at
100%, even at higher coverage
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Margin Risk Management: 2013 Farm Bill
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$4.00
Margin Risk Management: 2013 Farm Bill
$14.65
$2.25 $2.73
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DSA Income Over Feed Cost Margin
Coverage
House Senate
Prem.Net
Coverage Prem.Net
Coverage($/cwt)
4.00 0.030 3.970 0.000 4.0006.00 0.185 5.815 0.150 5.8508.00 1.060 6.940 1.060 6.940
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A commonly asked question:What does establishing a particular risk management objective mean in terms of the actual level of protection for my farm?
Let’s use LGM-Dairy as an example Establishing an IOFC floor What is (Your Farm’s IOFC − LGM-Dairy
IOFC) basis?
Margin Risk Management and Your Farm
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The LGM-Dairy’s IOFC is calculated by valuing milk at Class III price and standard composition
How does your farm’s mailbox price compare with Class III What is your (Mailbox – Expected
Class III) basis? → Expected Mailbox = Expected
Class III + the above basis
Component% of Vol.
Water 87.82
Butterfat 3.50
Protein 2.99
Other Solids 5.69
Standard Class IIIMilk Composition
Margin Risk Management and Your Farm
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LGM-Dairy’s IOFC is calculated by valuing insured feed use by CME futures market valuation Do you know your corn and SBM basis?
Feed price basis = your local price – futures price
With known basis Actual feed costs = declared feed use x local feed price
= declared feed use x (futures price + feed basis)= LGM-Dairy feed costs + (feed use x feed basis)
Margin Risk Management and Your Farm
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Using the above we have Actual IOFC = LGM-Dairy IOFC
+ (Class III basis x cwt) – (Feed basis x declared feed use)
With known basis you can determine what LGM-Dairy IOFC floor means in terms of your farm’s IOFC
Depends on Ability to estimate milk value and feed basis How variable are they?
Margin Risk Management and Your Farm
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We have only covered a few of the alternatives available for managing margin volatility
Need to know your costs of production to establish appropriate target
No such thing as a free lunch Risk-Return trade-offs What level of trade-off is acceptable to
you?
Margin Risk Management and Your Farm
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Contact Information
The Univ. of Wisconsin Understanding Dairy Markets Website: http://future.aae.wisc.edu
Livestock Gross Margin Insurance Website: http://future.aae.wisc.edu/lgm_dairy.html
Copy of this presentation: http://future.aae.wisc.edu/publications/
expo_13.pptx
Brian W. Gould(608)263-3212